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VOL. 38 | NO. 39 | Friday, September 26, 2014

The robotic rise of the S&P 500

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The S&P 500 hit a new all-time high again last week for the 34th time so far this year. However, U.S. stocks appear increasingly detached.

While the S&P 500 has risen nearly 10 percent year-to-date, stocks outside the US have returned less than 3 percent. In fact, U.S. stocks have pummeled their international competition by an astounding 70 percent over the last five years.

Due to such a torrid advance, U.S. stocks no longer present compelling value. But that has not deterred investors.

Quantitative analysis from William Blair shows US stocks should return 4.6 percent annually over the next eight years, while European and emerging market stocks should return 11.1 percent and 12.2 percent, respectively.

Countless others prepare these quantitative projections, as well, and they all reach similar conclusions.

U.S. stocks do not present investors with as compelling future return opportunities as international stocks. So why do they keep rising so relentlessly?

U.S. registered mutual funds and exchange traded funds (ETFs) hold nearly $17 trillion in assets, according to ICI. As the influence of managed money has grown through advisors, 401(k)s, variable annuities, etc., the amount of money held outside these vehicles in stocks directly has plummeted.

During the last 10 years, households have allocated $368 billion annually to investment companies, while divesting $323 billion from stock and bond investments owned directly.

To accommodate this surge in assets, there are now over 9,000 mutual funds and 1,300 ETFs.

However, the bulk of the assets reside with the largest players, as the top 10 mutual fund complexes manage over 50 percent of industry assets.

The fastest grower among them is the $3 trillion Vanguard group, the Malvern, Pennsylvania, founder of index investing.

Vanguard claims six of the top 10 stock mutual funds, and 80 percent of the assets within the top 10 are indexed to the S&P 500.

Since 2007, nearly $800 billion has flowed into index fund equity strategies. Of the total held in index funds, over half mirror the S&P 500. These massive flows have overpowered other classes and looted the funds out of traditional actively managed stock picking strategies.

For the period, that index funds attracted $800 billion, actively managed equity products shed $575 billion.

With investors migrating from stock picking into funds, and within funds from active to passive, the amount of money flowing into strategies that track the S&P 500 dwarfs everything else. The relentless rise in the S&P 500 can therefore be partially explained by the relentless flow of assets.

Will this lead to a bubble? Over the last 12 months, Morningstar reports, nearly 75 percent of all mutual fund inflows went into index strategies.

Seventy-five percent of flows hitting stocks at prescribed proportions doesn’t suggest a great deal of due diligence.

Given the purchase automation of 401(k), pension, insurance and annuity pools, the flows will likely escalate further. With the majority of those flows robotically directed toward the S&P 500, the inflation mechanics are in place.

Whether it’s a bubble or not, perceptions of invincibility typically lead to humility.

David Waddell, who is regularly featured in the Wall Street Journal, USA Today and Forbes, as well as on Fox Business News and CNBC, is president and CEO of Memphis-based Waddell & Associates.

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